Is It Economists' Fault?

I set a new blog record a couple of weeks ago. I got three --- count 'em, three --- e-mails suggesting blog ideas in one day! Two were from family, so I'm not sure how those count. But still... one wasn't.

And so I'll write about the one. A friend --- he's both an accountant and now a Texan, but really he's OK --- sends this article asking why economists didn't do a better job predicting the recent financial collapse.

The author --- Robert Samuelson from Newsweek --- thinks it's because economists just don't spend time thinking about finance, and don't realize how important financial markets are to modern economies.

In my view, this claim is so wrong as to be silly.

Finance is "just" a field of economics, but it's a field that has received a lot of research emphasis in recent years. Every top business school has dozens of researchers working on financial economics problems. And it's not just b-schools... There are top finance researchers in econ departments at Harvard, Stanford, Chicago, and on and on. Why, Princeton started a finance department (within their econ department) and they don't even have a business school! Finance scholars have won multiple Nobel Prizes --- for the CAPM, option pricing, capital structure research, and there'll be more --- and so it's just plain nuts to think that economists don't realize how important finance is.

So what was the problem? Why didn't economic and financial models predict impending doom? Should we shoot the economists?

I think there are two answer to this question, and fortunately both are illustrated by articles that were in the WSJ op/ed section on July 8.

Answer #1 is that, despite all the research, there are still a lot of things that economists still don't understand. I don't think this is because economists are stupid or selfish or lazy or wrong-headed --- I think it's because the problems we study are actually pretty hard. And there's a nice illustration in our first article, Let's Treat Borrowers Like Adults, written by law professor Todd Zywicki. He makes the following point: Buying a dangerous toaster is bad for any consumer who buys it. But a financial transaction is only dangerous if the person who buys it doesn't know what he or she is getting into. And it's very hard for economists to look into the mind of a borrower and figure out what the borrower does or doesn't know about the transaction he or she has just entered into. We're working on understanding human decision-making better, but I think we're not there yet.

So shoot the economists for that if you want. But don't shoot us for not thinking about financial markets. (And please don't actually shoot anyone, economist or not.)

Answer #2 is that even the simple and obvious economics --- the stuff that we're pretty sure we have right --- gets ignored by politicians all the time. And there's a nice illustration of this in our second article, written by, of all people, Gordon Brown and Nicholas Sarkozy. In it, they argue that excessive "speculation" is causing problems in worldwide oil markets.

I don't even know where to begin on this one. Point #1 is that if volatility is really a problem for oil-market participants, the solution is for them to use the futures market to hedge. So it's really pretty easy to use a market-based solution to this problem. Point #2 is that speculation is a good thing --- as long as speculators bear the full costs and reap the full benefits of their actions. (Note that the real estate speculators described in Zywicki's article were able to walk away from their bad housing-market bets, and saddle the banks with the losses.) Speculation is good because it connects present and future prices. The only way to make money speculating is to correctly forecast future price changes. If you think prices will be higher tomorrow than today --- which means that oil will be relatively scarce in the future --- then you can make money speculating by buying today and selling tomorrow. This drives the today price up, and this sends exactly the right price signal to the market. It tells the market to begin conserving oil right now, which is exactly what we all should do if oil is going to be scarce in the future. Read this old Hal Varian NYT column for more.

Why do politicians ignore simple economics? Because they can, at times, care more about getting votes than putting good policy in place. Voters don't necessarily understand that speculation is a good thing, so it can be easy to score political points with articles like this.

And why aren't voters more savvy about basic economics? Well, you can shoot economists for that too.